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The logic behind this approach is that the return required by the investors is directly based on the risk profile of a company. This risk profile is adequately reflected in the return earned by the bondholders. Yet, since the risk borne by the equity investors is higher than that by the bondholders, the return earned by them should be higher. Hence this return is calculated as: Yield on the long-term bonds of the company + Risk premium.
The risk premium is a very subjective figure, which is arrived at after considering the various operating and financial risks faced by the firm. Though these risks are already factored in the bond yield, since by nature equity investment is riskier than investments in bonds and is exposed to a higher degree of the firm’s risks, they also have an impact on the risk premium.
